Leveraged ETF Boom Goes Global

Just as leveraged ETFs are prompting warnings from regulatory agencies and drawing criticisms from U.S. investors, these controversial funds are enjoying tremendous popularity in Europe, where ETF Securities has launched the first complete platform of 2x leveraged and 2x inverse leveraged funds tracking Europe’s most popular equity indexes. The funds offer both leveraged bull and bear market exposure to the following indexes:

Dow Jones EURO STOXX 50

FTSE 100

CAC 40

DAX

All of the new funds will be issued utilizing ETF Securities “third generation ETF model,” which the firm believes will offer increased price compettion, enhanced liquidity, and reduced counterparty risk for investors. This third generation model diversifies index replication across a consortium of the industry’s strongest financial institutions, whereas “second generation” ETFs use only a single counterparty. “First generation” ETFs replicate index returns by replicating the underlying holdings, thereby introducing potential tracking error resulting from rebalancing costs. Commenting on the launch of the new funds, Hector McNeil, head of sales and marketing at ETF Securities said, “It is clear that the continued issuance of ‘third generation’ ETFsgive investors peace of mind during these turbulent times.” With the launch of these funds, ETF Securities now manages 140 exchange-traded products with $12 billion in assest, establishing itself as one of the leaders in Europe’s ETF industry.

This significant expansion in leveraged ETF offerings in Europe comes at a time when these funds are enjoying tremendous popularity, but also attracting numerous criticisms, in the U.S. Morningstar’s Scott Burns recently made a case for subjecting these funds to the same regulations as their underlying holdings (derivatives), and his call has been echoed by countless parties in the industry. On Monday, the Financial Industry Regulatory Authority (FINRA) issued a warning to financial advisers reminding them of their fiduciary duty and implying that these leveraged funds are appropriate for only a very small percentage of clients.

The concern over leveraged ETFs is that while they offer sophisticated investors a powerful short-term investment tool, they are being used by both “average Joe” investors and dangerously ignorant financial advisers who do not understand exactly how these instruments work. While leveraged ETFs generally do an excellent job of tracking the daily performance of their target indexes, due to the compounding returns, performance over any period longer than a day can vary (sometimes significantly) from the amplified return on the underlying benchmark. ETF Securities fully acknowledges that these funds have a relatively narrow target audience, peppering warnings and disclosures throughout its literature on these products as well as its web site. ETF Securities notes that their funds are “only suitable for sophisticated investors who understand leverage, compounded daily returns, and are willing to magnify potential losses.”

Despite similar warnings and transparency from the primary U.S. issuers of leveraged ETFs, ProShares and Direxion, however, concerns over misuse continue. It will be interesting to see how these funds are received in Europe (I’m guessing they will be tremendously popular) and how much scrutiny they receive from both the public and the industry regulators. Hopefully our friends from across the pond will be able to provide some insight as to how we might solve the dilemma posed bythese securities.

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